Is the Stock Market Expensive or Not?

It’s a simple question that you and your friends want a direct answer to from number-crunching investment strategists: Is this stock market expensive or fairly valued?

Unfortunately for market participants, as in all matters of economics and finance, the frustrating and fun truth is that there is no one answer to this puzzle. More specifically, it all depends on the employed equity market valuation measure.

For instance, Brett Arends of MarketWatch writes today of his recent chat with James Montier, the highly regarded strategist at fund firm GMO. Montier, for his part, is one deeply worried market maven.

“This is the first officially government-sponsored market mania for a very long time,” he said, adding that assets aren’t as overvalued as they were in 2007 but they’re getting there. “We’re not completely priced for perfection, but we’re not far off. There’s no margin of safety left.”

Montier admits that betting against this market rally risks violating the first rule of Investing 101: Don’t fight the Fed. “The old adage, ‘Don’t fight the Fed,’ is one that you have to bear in mind,” he says. “But what I don’t want to do is compromise my standards of value. One of the most important things that investors don’t always have is an absolute standard of value. If the market gets too expensive, you should get out.”

So, is Mr. Market too expensive?

Certainly, by some gauges, one could make that case. For example, the Shiller P/E ratio for the S&P 500 - which uses the 10-average of inflation adjusted earnings - now points to a market that’s some 40% overvalued compared to the historical average. Check out the data here.

Other strategists, however, disagree with this analysis. For instance, James Stack of InvesTech Research argues that valuations are nowhere near the extremes that would represent the threat of an investment bubble.

Stack argues that, in 1999, at the peak of the high-tech bubble mania, the “500” sported a lofty P/E ratio of 33.9 based on trailing 4-quarter earnings. Today, the same trailing 4-quarter P/E ratio for the “500” is less than one-half that level, at a moderate 16.9. The 80-year average valuation is 17.

In short, Stacks says, you can’t have a bubble if there’s no extreme valuation because there’s no excess air to let out.